FASB Net Settlement Provisions

Derivatives Implementation Group

Statement 133 Implementation Issue No. A3

Definition of a Derivative:
Impact of Market Liquidity on the Existence of a Market
Mechanism

[Previously titled: Net
Settlement Provisions]

Paragraph
references:

6(c), 9(b), 57(c)(2)

Date cleared by
Board:

February 17, 1999

QUESTION

Does the liquidity of the market for a group of
contract affect the determination of whether under paragraph 9(b)
there is a market mechanism that facilitates net settlement under
paragraph 9(b)? For example, assume a company contemporaneously
enters into 500 futures contracts, each of which requires delivery
of 100 shares of an exchange-traded equity security on the same
date. The contracts fail to meet the criterion in paragraph 9(a)
because delivery of an asset related to the underlying is required.
The futures contracts trade on an exchange, which constitutes a
market mechanism under which the company can be relieved of its
rights and obligations under the futures contracts. However, the
quantity of futures contracts held by the company cannot be rapidly
absorbed in their entirety without significantly affecting the
quoted price of the contracts.

RESPONSE

No. The lack of a liquid market for the group of
contracts does not affect the determination of whether under
paragraph 9(b) there is a market mechanism that facilitates net
settlement because the test in paragraph 9(b) focuses on a singular
contract. The exchange offers a ready opportunity to sell each
contract, thereby providing relief of the rights and obligations
under each contract.

Paragraph 57(c)(2) elaborates on the phrase market
mechanism that facilitate net settlement and states that "any
institutional arrangement or other agreement that enables either
party to be relieved of all rights and obligations under the
contract and to liquidate its net position without incurring a
significant transaction cost is considered net settlement." The
possible reduction in price due to selling a large futures position
is not considered to be a transaction cost under that
paragraph.

Whether the number of shares deliverable under the
group of futures contracts exceeds the amount of shares that could
rapidly be absorbed by the market without significantly affecting
the price is not relevant to applying the criterion in paragraph
9(b).

The above response has been authored by the FASB
staff and represents the staff's views, although the Board has
discussed the above response at a public meeting and chosen not to
object to dissemination of that response. Official positions of the
FASB are determined only after extensive due process and
deliberation.